Blind Squirrels don’t find that many nuts, Index Funds are best.

by Grant Ross

 As much as your Uncle Brian tells you he knows a guy who manages his mutual fund, and gives him constant positive returns, do not believe him. Index funds almost always perform better than mutual funds over the long run and are a much better investment.

To start, an index fund is a form of investment that is meant to match the overall market, and give returns accordingly. Index funds achieve this by having a portfolio of extremely diversified stocks. Index funds are passively managed as the manager is just trying to mimic the market, and not pick winning stocks. While mutual funds are a selective portfolio of stocks, that are designed to beat the market, and give returns accordingly. Mutual funds are considered “active” as the fund managers are always picking what they think will be winning investments.

Even if there is an off chance that the mutual fund Uncle Brian invested in gave returns better than the S&P 500 he will still not get to keep all of that money. This is because mutual funds have much higher management expenses. According to The Balance, index funds typically have an expense ratio below 0.2%, whereas mutual funds will have expense ratios that are around 1.5%. The implicit cost of the whole percent greater expense ratio means that your Uncle’s mutual fund will have to perform one percent better than the market, to be worth it compared to an index fund.

On top of that almost all mutual funds do not perform better than the market. NerdWallet found that over the course of fifteen years, more than 90% of American mutual funds performed worse than the S&P 500 returns, using S&P Dow Indices data as its source. And on an individual year basis, Daren Fronda from Baron’s reported that only 29% of mutual fund investors beat their benchmark in 2019. Clearly mutual funds are extremely risky, and almost always not worth investment as you are giving up the opportunity cost to invest that money into an index which gives an annual return of around 5.02 percent.

The reason that the difference between the one year percent of investors that beat the mean and the 15 year is that on a one year basis is so great, is because mutual fund investors will get lucky on a one year basis eventually most mutual funds will eventually return to the mean. Researches at Kennesaw said that performances of mutual fund investments will go up and down, but data they tracked shows it will regress to the mean over time. The researchers related mutual fund investing to the game blackjack. If you’ve ever played blackjack, you know that you can be somewhat skilled at the game, but a lot of your performance depends on having the hot hand, and eventually the luck will run out. However, for some mutual fund investors, luck is not the only factor as they seemingly can beat the market on average. A paper written by researchers from MIT stated, “The average fund earns back less than three-quarters of its expenses in excess returns on investments… if one looks at a fund with the mean expense ratio we find very weak evidence that managers from higher-SAT schools are able to beat the market… a hypothetical fund with expenses at the 25th percentile our point estimates are that even a manger from a school with an average SAT of 1046 would be expected to beat the market.” In short, this means that even the smartest mutual fund managers cannot beat the market with average expense ratios, but most fund managers can beat the market with low fund ratios.

Let’s say your mutual fund manager has against all odds, beaten the market repeatedly and is outperforming index funds, giving you greater returns. Now, the fund manager has become popula, meaning the demand for their managed mutual fund is greater and more people are pooling into the fund. This may cause the fund manager to have a style drift, where they make different investments, typically putting more money into more well known stocks to appeal to all their new customers. This is extremely bad news for you, however, as now the risk and reward ratio of the fund has completely changed. Resulting in regression to the mean, which is a three quarter return on the original investment.

Index funds are a much safer bet than mutual funds, and almost always yield higher returns. When you are making investments, consider taking a very deep dive into the mutual fund that you are considering, otherwise stick with an index fund. 

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Works Cited

AliciaAdamczyk. “Index Funds Are More Popular than Ever-Here's Why They're a Smart Investment.” CNBC, CNBC, 19 Sept. 2019, www.cnbc.com/2019/09/19/why-index-funds-are-a-smart-investment.html. 

Fonda, Daren. “If You Still Own Actively Managed Stock Funds, Get Ready for Some Bad News.” Barron's, Barrons, 23 Jan. 2020, www.barrons.com/articles/if-you-still-own-actively-managed-stock-funds-get-ready-for-some-bad-news-51579691701. 

“The Journal of Finance.” Are Some Mutual Fund Managers Better than Others?: Cross-Sectional Patterns in Behavior and Performance, by Judith A. Chevalier and Glenn Ellison, National Bureau of Economic Research, 1996, pp. 875–896. 

Plaehn, Tim. “What Is the Rate of Return on an Index Fund?” Finance, 21 Nov. 2017, finance.zacks.com/rate-return-index-fund-6679.html. 

Thune, Kent. “Why Index Funds Beat Actively Managed Funds.” The Balance, 25 June 2020, www.thebalance.com/why-index-funds-beat-actively-managed-funds-2466411. 

Whitlark, David B. “Hot Hand, Regression to the Mean and Unmet Expectations: Marketing the Mutual Fund Mirage.” Kennesaw, 2019. 

Yochim, Dayana. “Index Funds vs. Mutual Funds: The Differences That Matter.” NerdWallet, 16 Oct. 2020, www.nerdwallet.com/article/investing/index-funds-vs-mutual-funds.